THE SEPT. 1, 1998 ISSUE OF Public Utilities Fortnightly contained an article, "The Fortnightly 100," which promised to reveal America's "most efficient utilities." The authors used data...
21st Century ROEs: What Is Reasonable?
the 10 percent rate of return order discussed above.) Figure 1 shows that the average of allowed ROEs has been between 11.1 percent and 11.3 percent in recent years. In 2001, at the time of the discussed rate case, the range of recently allowed ROEs spanned from a minimum of 10.3 percent to a maximum of 12.9 percent. However, given the rating agencies' concerns about the inadequacy of currently allowed rates of returns, the lower end of this range is unlikely to be consistent with adequate compensation of investors' capital. When 25 percent of the lowest allowed ROEs are excluded, the resulting lower bound of allowed ROEs (i.e., the first quartile) has been between 10.75 percent and 11 percent in recent years.
The red markers and underlined labels in Figure 1 indicate the ROE recommendations for staff, public counsel, and the company in the discussed rate case example. Compared to these recommendations, the range of recently allowed ROEs clearly illustrates that: (1) the utility's recommendations of 11.5 percent to 12 percent was within the range of state commissions' recently allowed ROEs; (2) the public counsel's recommendations of 10 percent to 10.25 percent was just below the lowest ROE authorized by any other state commission in the last few years; and (3) the staff's recommendation of 8.5 percent to 9.5 percent fell substantially short of any recently-allowed ROEs in the entire country.
The gray markers in Figure 1 also plot the staff's midpoint ROE recommendations in 11 other recent rate cases before the same commission. The data show that staff's recommendations in 1997 were substantially consistent with the low end of state commissions' allowed ROEs. They also show that, since then, staff's recommendations became increasingly disconnected from any returns allowed by utility regulatory commissions. In one of the more recent rate cases shown on this chart, the difference between staff's midpoint recommendation of 9.4 percent and the average of ROEs allowed by U.S. state commissions reduced the utility's annual revenue requirement by more than $60 million.
The benchmarking of ROE recommendations against allowed returns by other commissions not only makes staff's recommendations highly suspect, it also makes the public counsel's 10 percent to 10.25 percent questionable as an appropriate "midpoint" recommendation. In fact, if staff's recommendation had been rejected, the midpoint between the public counsel's and the utility's recommendations would have been 11 percent-a return on equity that, while still below the average of recently allowed ROEs, would have been more consistent with the mainstream of returns allowed by other commissions in the country.
Of course, such benchmarking cannot be a substitute for the proper estimation of the regulated company's cost of capital. Solely relying on the allowed return of other regulatory commissions to set the allowed return is unlikely to result in a proper estimate of a company's cost of capital and can lead to serious circularity problems. 5 It must also be taken into consideration that benchmarking relies on past allowed returns for many different companies, while allowed returns apply to a specific utility's rates over the next several years. As